Speech
Australian Economic Growth – The How, What and Where

Introduction

I'd like to thank the Board and members of the RSL & Services Clubs Association
for their invitation to speak here.

I want to consider three closely related questions I am often asked:

How can the Australian economy become more productive?

What will help generate additional growth (in demand) needed to boost employment?

Where is that growth going to come from? In particular, which industries will have
the profitable opportunities that will lead to more employment and drive investment?

It is hardly surprising that Australians are interested in these questions given
the rise in the unemployment rate and sub-trend growth of the economy over
the past couple of years.

How to be more productive?

From the middle of the previous decade, Australia enjoyed a sharp run-up in the prices
of our key commodity exports. This led to an unprecedented boom in mining investment.
The benefits were spread beyond the narrow confines of the mining industry
in numerous ways, with strong growth in employment and wages across a range
of industries around the country.[1]

But now that commodity prices and mining investment have turned down, it is natural
to ask: how are we going to sustain and build on our standard of living over
the longer term? This boils down to two essential elements. We can work more
(i.e. raise our labour force participation). We can also work more efficiently.
In other words, we can boost our (labour) productivity, which is the source
of sustainable gains in wages and profits (in the absence of a resurgence in
commodity prices).[2]
I've spoken elsewhere about participation, so let me focus here on productivity.[3]

There are a number of sources of growth in labour productivity (i.e. output per hour
worked):

technological progress, which supports new business processes and new production
techniques as well as more efficient use of productive resources. In other
words, an expansion of the technological, or productive frontier

additional physical capital, both private and public, some of which may embody new
technologies

more human capital (via education and training).

These things have a somewhat formulaic air to them. They suggest that we just need
the right combination of inputs so as to produce goods and services as efficiently
as possible. But for that to lead to sustainable growth of incomes –
of wages and profits – we need to make sure that the goods and services
produced are those that people want at a price they are willing to pay. Also,
we need to fund investment from domestic or foreign sources of savings, which
are provided with the expectation of a reasonable return.

A market-based economy can achieve these things with the help of competitive and
flexible labour and product markets.[4]
These provide the price and wage signals that encourage labour and capital to move
into profitable opportunities and out of unprofitable ones. Competitive markets
also encourage companies to seek out efficiency gains and pursue innovations.
Developing new products or processes and taking advantage of scientific progress
are key drivers of long-term growth.

It helps too for those markets to be supported by a robust institutional framework,
such as: the rule of law; effective regulation and oversight of parts of the
economy, including to ensure the soundness of the financial system; and institutions
to oversee the efficient provision of public services and infrastructure, and
encourage prudent management of fiscal and monetary affairs.

Productivity growth was especially strong across many countries, including Australia,
over the decade starting in the mid 1990s (Graph 1). There may have been
some common sources to this strong growth. An obvious candidate is technological
progress.[5]
In the case of Australia, and a number of other countries, a range of earlier economic
reforms may also have played a role. These included a broad-based deregulation
of financial, product and labour markets, further liberalisation of international
trade and a program of corporatisation and privatisation of public enterprises.[6]
While these things don't push out the technological frontier, they provide an
environment that encourages and enables us to get closer to that frontier.

Following this period, there was time from the mid 2000s during which productivity
growth was considerably slower than its longer-term average. This slowdown
was also common to a number of economies.[7]

However, productivity growth has picked up in Australia over more recent years. Some
of this reflects the move from the investment to the production phase of the
mining boom, which has seen a strong rise in output combined with a reduction
in employment in resource-related activity. But the pick-up in productivity
growth is broadly based across other sectors of the economy. This may, in part,
reflect the response of businesses to rising competitive pressures following
the period when the exchange rate had risen to very high levels, growth of
non-mining activity had been relatively weak and wage growth relatively strong.
Responding to those pressures is not easy. A common theme from the Bank's
liaison program in recent years has been the heightened focus on reducing costs
and improving productivity in response to the subdued growth in demand. In
more extreme cases, however, it involves businesses that are not sufficiently
productive going out of business and workers losing their jobs.

Graph 1

What more could be done to secure strong productivity growth? As others have noted
before me, the experts at the Productivity Commission have put together a ‘list’
of what could be done.[8]
The list describes how improvements to incentives, capabilities and flexibility could
enhance productivity. Again, the idea is not that these things can push out
the technological frontier, but they can help us get closer to it. Recommendations
to improve incentives largely focus on promoting competition, such as further
reducing barriers that inhibit international trade or new entrants to markets.
Policies on capabilities focus on the development of human capital, improving
infrastructure and government services as well as the institutions for creating
and transmitting knowledge (academic institutions and their links with the
business community, for instance). The third part of the list deals with providing
a more flexible regulatory environment and reducing unnecessary ‘red
tape’. Any one policy will be helpful by itself, but it is likely that
the combined effect will be greater than the sum of each of the parts.

This discussion has focused on how economies can support growth over the longer term. You will note,
however, that I haven't said much about the role of monetary policy. While
monetary policy can help to ensure low and stable inflation, and contribute
to macroeconomic stability, it cannot influence the longer-term determinants
of growth. Even so, monetary policy has an important role in influencing economic
activity over the course of the business cycle, which is the subject of the
next question.

What will help generate additional growth in demand over
the next couple of years?

Since about mid 2012, Australia's GDP growth has been a bit below trend and so
the unemployment rate has been rising gradually (Graph 2).[9]

Graph 2

The Bank's recent update to its forecasts has pushed out the time at which we
see GDP growth picking up from its current sub-trend pace. It is not that economic
growth has weakened of late. But there is little to suggest that it will increase
in the near term.

This implies that the unemployment rate will rise for a bit longer and peak a bit
higher than previously expected. The question then is what is it that will
generate an improvement in the rate of economic growth and lead to a decline
in unemployment? What are the triggers for such a revival?

Part of the answer is that the very low level of interest rates is expected to sustain
strong activity in the housing market and support household wealth. This will
provide some support for consumption, although the response of consumption
to low rates may be somewhat less and work in different ways from previous
episodes, in part because of the higher levels of household indebtedness now.[10]
Low interest rates also work by raising overall cash flows for the household sector
(since households are borrowers in net terms) and by encouraging households
to bring forward some spending and lower their saving rate a little further.

Looking back over the past year we can see the effect of low interest rates at work.
Dwelling investment has grown strongly and made a contribution to demand across
all the states (Graph 3). Consumption growth has picked up a bit, particularly
in New South Wales, but it remains a bit below average for the nation as a
whole. Consumption growth is weakest in Queensland and Western Australia, which
are dealing with the direct effect of the decline in mining investment. Business
investment is making a positive contribution to growth in the other states.
Meanwhile, in line with fiscal consolidation at state and federal levels, public
demand has made no contribution to growth for the country as a whole, but the
contribution is mixed across the different states.

Graph 3

In time, a pick-up in household demand should encourage businesses (outside of the
resources sector) to increase employment and undertake more investment. When
that occurs, businesses will make more use of funding that is currently readily
available at low cost. Also, exports, especially of resources – most
notably liquefied natural gas (LNG) – are expected to continue to contribute
significantly to growth, while declining mining investment and, to a lesser
extent, fiscal consolidation are likely to weigh on growth over the next couple
of years.

It's tempting to think that economies are well served by being directed or guided
in a way that will produce better outcomes. There is some truth to that. Monetary
policy is certainly playing an important role, but it guides things rather
imprecisely, with the relatively blunt tool of the overnight cash rate.

Other means of adjustment

Economies are responsive in many other ways that don't require the active input
of policymakers. The so-called ‘invisible hand’ of markets can
provide the incentives for producers and consumers to alter their behaviours
via a range of price signals.

The exchange rate provides one such signal. The earlier substantial appreciation
of the Australian dollar in response to very high prices for our commodity
exports was a signal for labour and capital to move into the resources sector.[11]
But, for a time, the Australian dollar stayed high even after mining investment and
commodity prices began to turn down. That meant that it was not playing the
usual role of helping to rebalance growth towards other parts of the economy.

However, the Australian dollar has depreciated by nearly 20 per cent (on a trade-weighted
basis) since its peak in mid 2013 and is starting to play a role in helping
the economy to adjust. Australians and foreigners will direct more of their
spending to Australian produced goods and services (such as tourism and education)
as they become relatively cheaper compared with the alternatives available
offshore. Along the same lines, the depreciation has lowered the level of Australian
wages when measured in foreign currency terms; since April 2013, they are
30 per cent lower in US dollar terms.

While the depreciation seen to date will be helpful, our assessment is that our exchange
rate remains relatively high given the state of our overall economy.

A change in the growth of wages (in Australian dollar terms) is also an important
source of adjustment. Just as wage growth picked up when conditions in the
economy were stronger, the growth rate of wages has declined substantially
since 2012 (Graph 4). The lower growth of wages works to depress the growth
of incomes for those in employment. At the same time, however, lower wage growth
allows for more employment than would otherwise be the case, which works to
support the growth of total labour incomes. In a similar vein, the pick-up
in productivity growth over recent years means that the cost of obtaining the
labour required to produce a unit of output (the unit labour cost) has not
changed for three years.

Graph 4

In summary, the economy is currently operating somewhat below its productive capacity.
The forecast is for a gradual increase in the growth of demand and employment,
and eventually a rise in non-mining business investment, supported by the very
low level of interest rates. The lower exchange rate will offer some support
to demand for Australian produced goods and services. Adjustments are also
occurring along other dimensions, such as gains in productivity and slower
growth of wages, both of which will help place the economy on a stronger footing.

So that is what I think can help, in time, to generate some more growth. It is
based on a macroeconomic perspective, and draws on knowledge of the history
of business cycles. It's only natural though to want more tangible evidence
regarding the prospects for growth. That is,
where is the growth going to come from more specifically?

Where is the growth going to come from?

In some ways this is the hardest of the three questions. It is difficult to know
what new products and companies will come along, and which products and companies
they might displace. And while no doubt there will be further technological
progress and innovation, it is hard to predict how this will affect specific
industries, especially for those not yet in existence! Nevertheless, we can
say a few things about the general forces and trends that are likely to be
with us for a time.

One such trend is the increasing importance of household and business services in
the economy. Over the past
30 years, households have increased the share
of their spending devoted to services, from about 53 to 65 per
cent of their total consumption (Table 1). Health and education
account for a large part of that. Households are also spending a larger share
of their growing incomes on recreation and leisure services, as well as communication
and financial services. The shift in spending away from goods reflects, in
part, the fall in the relative prices of goods. In turn, that reflects stronger
productivity growth for goods relative to services as well as the development
of lower-cost manufacturers in emerging economies. That is, the world has become
much better at producing goods. Mirroring these trends in consumption and production,
the share of employment in household services has increased from 25 to 33 per
cent over the past 30 years. This includes employment in accommodation and
food, arts and recreation, education and training, and health care and social
assistance. These are all things we want and need more of as our appetites
for goods becomes more easily satisfied.

Table 1: Household Consumption Expenditure Shares
Per cent

1984

2014

Goods

47.5

34.9

Services

52.5

65.1

Accommodation and food

7.1

6.8

Education

2.0

4.6

Health care

4.5

6.3

Arts and recreation(a)

3.8

5.2

Communications

1.4

2.3

Air travel

1.2

2.0

Financial services(b)

6.8

8.9

(a) Services component only
(b) Includes insurance and other financial services

Sources: ABS; RBA

Business services have increased substantially as a share of output and employment.
In part this is because it has become increasingly cost-effective for businesses
to outsource a lot of their ‘non-core’ functions to other more
specialised industries. For example, accountants that used to work for a manufacturing
firm may now be in the ‘business services industry’ helping out
a wide range of different companies.

Resource production and exports are likely to continue to grow strongly for the next
few years as the new LNG facilities ramp-up production. While many people across
a wide range of industries helped to build those facilities, a much smaller
workforce is required once they enter into production. Mining more generally
is likely to continue to account for a relatively small share of total employment.

Manufacturing output has increased over the past few decades as a whole, but not
as much as output from other industries. This is common to most developed economies,
reflecting the increased demand for services and the emergence of lower-cost
manufacturers in emerging economies. The high level of the Australian dollar
has also weighed on manufacturing over recent years.[12]
Those manufacturers with more exposure to the construction industry (including in
mining) and focused on more complex, highly skilled techniques have tended
to fare better than those exposed more to the pressures of international competition
from emerging markets.

The depreciation of the Australian dollar over the past year or so is expected to
support expansion of industries in the traded sector. This will benefit both
goods and service industries exposed to trade. Exports of services, which include
education and tourism as well as business services, were worth about $60 billion
in 2014, and at current prices were a touch higher than iron ore exports at
the end of last year (Graph 5).[13]
Most of the growth in services exports is attributable to rapidly growing economies
in the Asian region. These service industries should benefit from further strong
growth of demand from that source, with many more households in Asia gaining
a foothold in the middle class. While Australia has many strengths in these
service industries, our comparative advantage here is perhaps not as obvious
as it is in mining and agriculture, which benefit from our substantial endowments
of natural resources. This means that we will need to continue to work hard
to maintain competitiveness in these global markets.

Graph 5

Conclusions

The Australian economy has good prospects for growth over the longer term. Among
other things, we have the advantage of a well-educated workforce, strong population
growth and a robust institutional framework. Also, we are closer to a rapidly
developing part of the world than we are to many slower growing developed economies.
We have benefited too from earlier reforms. Among other things, this has left
us with more flexible and competitive product and labour markets than we had
in the past and helped us to get closer to the technological frontier. However,
other countries will continue to pursue reforms and we can't rest on our
laurels.

The Bank's central forecast for economic activity is for growth to gradually
pick up over the course of the next couple of years. Monetary policy has been
and will continue to play its part in this regard. The depreciation of the
exchange rate seen to date is helpful. And we shouldn't forget that there
are other sources of adjustment, including the pick-up in productivity growth
over recent years.

However, as we've emphasised regularly, forecasting is difficult, there are many
uncertainties and better growth is not guaranteed. It is also difficult to
know exactly where growth will occur. The very low level of interest rates
suggests that the housing market is likely to remain strong. We will probably
see a continuation of trends such as the growing importance of the services
sector in our economy, which is relatively intensive in terms of employment.
Resource production and exports are less employment intensive, but the significant
investment in that sector will continue to bear fruit for a long time. Finally,
a lower exchange rate will provide support for demand for the output of the
wide range of firms operating in the tradable sector.

Endnotes

I thank Kathryn Davis, David Jacobs and James Wang for excellent assistance in preparing
these remarks.
[*]

The decline in the unemployment rate following the run-up in the midst of the global
financial crisis is interesting given that average GDP growth over that period
was not especially strong (at 2¾ per cent per annum). The decline
in the unemployment rate may, in part, reflect an unwinding of the earlier
rise in unemployment, which was relatively large compared with the early
2000s slowdown (for which average GDP growth was similar). It may have been
that businesses anticipated a more significant slowdown in demand during
the global financial crisis than occurred, leading the unemployment rate
to ‘overshoot’, with a correction thereafter.
[9]